Seminal Court Cases and Their Impact on Transfer Pricing ... - NABE

<strong>Seminal</strong> <strong>Court</strong> <strong>Cases</strong> <strong>and</strong> <strong>Their</strong> <strong>Impact</strong> on
Transfer Pricing Practice <strong>and</strong> Procedure
Rocco Femia, Miller & Chevalier
John Magee, Bingham McCutchen
Irving Plotkin, PWC
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Agenda
• Overview of seminal transfer pricing cases
• Lessons learned
• Application – Xilinx <strong>and</strong> Veritas
• Implications for future transfer pricing litigation
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Caveat Lector
• Decided transfer pricing cases are intensely factual
• <strong>Court</strong>s sometimes appear to adopt methodologies
driven by desire to reach result somewhere between
position of two parties
• Limit to lessons that can be drawn from cases
• Virtually all transfer pricing disputes are resolved
short of litigation
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U.S. Steel (2d Cir. 1980, rev’g Tax <strong>Court</strong>)
Primacy of Internal CUPs
• USP purchased shipping services from FSub
• Prices equal to prices charged to uncontrolled
companies for shipping of much smaller quantities
• USP could have procured services for less
• <strong>Court</strong> adopts internal CUP analysis
• Consider viability of decision post 1994 regulations
<strong>and</strong> “realistic alternatives” st<strong>and</strong>ard
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du Pont (Ct. Cl. 1979, aff’g Ct. Cl. trial dec. 1978)
Use of Financial Ratios
• USP sold goods to distributor (FSub)
• At trial, taxpayer justified prices based on resaleminus
analysis <strong>and</strong> on industry-average gross margins
• IRS experts noted FSub’s relatively low selling costs
over net sales, <strong>and</strong> other differences with comps
• IRS experts supported IRS adjustment with analyses
based on operating margin <strong>and</strong> return on capital
• <strong>Court</strong> sustains IRS adjustment <strong>and</strong> foreshadowed
multiple features of modern transfer pricing analysis
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Hospital Corp. of America (Tax <strong>Court</strong> 1983)
Transfer of Business Opportunities
• USP formed FSub to perform under contract with
uncontrolled party
• Most substantial work done by USP
• IRS argued that all profits of FSub should be
reallocated to USP
• <strong>Court</strong> rejects argument that transfer of business
opportunity required allocation of all resulting profits
• <strong>Court</strong> resorts to profit split to allocate 75% of FSub
income back to USP
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Bausch & Lomb (2d Cir. 1991, aff’g Tax <strong>Court</strong> 1989)
Respect for Transactions as Structured
• USP moved low-cost manufacturing capability (<strong>and</strong>
related manufacturing IP) to FSub
• Products sold back to USP priced per external CUPs
• Royalty for manufacturing process based on
projected profitability of FSub
• IRS argued that FSub should be compensated for its
functions as contract manufacturer
• <strong>Court</strong> rejects IRS approach, adopts CUP analysis,
but increases royalty to split projected profits 50/50
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Westreco (Tax <strong>Court</strong> 1992)
Limited Returns for Limited Risk
• USSub performed R&D services for FP,
compensated on a cost-plus basis
• IRS initially used “salary multiplier” method, <strong>and</strong> then
financial data of “comparable” companies in same SIC
code, to justify adjustment
• <strong>Court</strong> rejects IRS position because data did not
account for reduced risk undertaken by USSub, among
other differences
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Compaq (Tax <strong>Court</strong> 1999)
Constructed CUPs (or Prices vs. Profits)
• USP moved low-cost manufacturing process to FSub
• Products sold back to USP priced per cost plus
• At trial, USP justified prices based on prices paid to
uncontrolled suppliers for similar products in
consignment (rather than buy/sell) arrangements
• Adjustments to CUPs > CUPs
• IRS argued that profitability of FSub was too high
based on functions
• <strong>Court</strong> rejects IRS approach, adopts CUP analysis
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UPS (11th Cir. 2001, rev’g in part T.C. 1999)
Business Purpose <strong>and</strong> Transfer Pricing
• USP charged “excess value charge” to customers to
insure packages
• USP restructured operations by reinsuring EVC with
foreign affiliate (through uncontrolled intermediary)
• IRS argued that arrangement had no business
purpose <strong>and</strong> should be shammed; Tax <strong>Court</strong> agrees
• Eleventh Circuit disagrees, <strong>and</strong> recasts issue as a
transfer pricing issue (e.g., the appropriate
compensation for reinsurance)
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DHL (9th Cir. 2002, aff’g & rev’g in part T.C. 1998)
Scope <strong>and</strong> Ownership of IP
• USP transferred WW trademark to foreign affiliate
• Tax <strong>Court</strong> fixes value of IP <strong>and</strong> similar attributes at
$300M, or value of business above book value
• Tax <strong>Court</strong> allocates IP value 50/50 as between WW
trademark rights (compensable) <strong>and</strong> transferee
delivery network (not compensable)
• Ninth Circuit further holds that transfer of foreign
trademark rights are not compensable because they
were already “owned” by transferee
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Xilinx (9th Cir. 2010)
• USP <strong>and</strong> FSub are parties to cost sharing
arrangement
• USP does not reflect stock options in cost pool
• Taxpayer proffers evidence that parties in similar
arrangements do not share stock option expense
• IRS expert argues that failure to share would lead to
distortion of income
• Ninth Circuit ultimately holds for taxpayer on basis of
evidence from arm’s length dealings
• 2003 regulations intended to reverse holding
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Veritas (Tax <strong>Court</strong> 2009)
• USP enters into cost sharing arrangement with FSub
• USP transfers pre-existing IP for buy-in payment
• USP defends buy-in payment based on CUT analysis
with reference to uncontrolled licenses of same IP
• IRS expert argues that transfer was akin to sale of
foreign business <strong>and</strong> should be compensated by
expected future profits under income method
• <strong>Court</strong> holds in favor of taxpayer, but requires
adjustments to CUTs
• 2009 regulations explicitly adopt income method
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Xilinx <strong>and</strong> Veritas
• Decisions in Xilinx <strong>and</strong> Veritas are not aberrations
• <strong>Court</strong>s often rely on actual uncontrolled transactions
even where comparability is tenuous
• <strong>Court</strong>s often reject IRS efforts to recast transactions
• <strong>Court</strong>s often reject IRS arguments based on broad
principles rather than facts at issue
• Allocations of rights to earn income in the future may
not be compensable
• Showing of “undue” profit may not be enough where
transactional analysis supports result
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Future of Tax Litigation
• Outside of cost sharing, virtually no cases decided
under modern (1994) regulations
• Virtually all transfer pricing disputes decided under
framework of regulations short of litigation
• APA <strong>and</strong> competent authority programs provide an
outlet to address potentially contentious arrangements
• IRS has established Transfer Pricing Practice to
better coordinate h<strong>and</strong>ling of key cases <strong>and</strong> identify
emerging issues
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